What is meant by Cost of Capital?
Cost of Capital can be defined as the company’s calculation of the minimum amount of return that is required that would be necessary in order for a process to be considered acceptable. The concept of cost of capital is mostly used when undertaking, or further justifying a capital budgeting project, like the construction of a new factory.
This term is widely used by analysts and investors. However, it is mostly an evaluation regarding the efficacy of an investment’s potential return in relation to its costs as well as risks. Mostly, companies rely on debt and equity to finance the business expansion. In that case, cost of capital is mostly derived from the weighted average of all capital or financing sources that the company has. This is referred to a Weighted Average Cost of Capital (WACC).
Understanding Cost of Capital
The main reason and rationale behind companies calculating the Cost of Capital is to determine the hurdle rate of a given project. The hurdle rate is then used to decide on the efficacy of a given project. Any company that embarks on a major project is ideally supposed to know how much money the project will require in order to make sure that the project continues to stay profitable, in terms of the cost related investment.
Cost of Capital is used from the perspective of an investor, is an estimation of the return that is expected from acquisition of stock shares or any other given investment.
Formula for calculating Cost of Capital
Cost of Capital is calculated using a multitude of factors, including Cost of Equity, as well as Cost of Debt. The formula to calculate Cost of Capital is as follows:
Cost of Capital = RE × [Equity / (Debt + Equity)] + RD [Debt / (Debt + Equity)] × (1 – Tax Rate)
Where,
RE = Cost of Equity
RD = Cost of Debt
Equity = Market Value of Equity
Debt = Market Value of Debt
However, it must be noted that the formula above for calculating Cost of Capital does not incorporate any inflation, or any concept of time value of money. Therefore, Cost of Capital that is derived using this formula is referred to as Nominal Cost of Capital. It does not factor inflation, or time value of money. In the case where the company wants to readjust or realign it in accordance to inflation, they need to make amendments and adjustments so that a realistic picture of the actual financial position of the company is made possible.
Nominal Cost of Capital
The Nominal Cost of Capital is considered to be a rate that is inclusive of inflation. It mainly refers to the Nominal Cost of Capital calculation does not factor in inflation.
Inflation is a concept that impact financial decisions quite significantly. As a matter of fact, it can be seen that time value of money is not properly factored in the calculations, and therefore, the derived results might not be representative of the actual financial position of the company.
Therefore, it can be seen that while nominal cost of capital tends to be important in terms of helping companies getting a general idea regarding financing, yet it might not be a fully representative view of the actual financing position of the company, to say the least.
Real Cost of Capital
The Real Cost of Capital, on the other hand, is a rate that factors in inflation and time value of money from the perspective of the company. Hence, this is a more realistic metric that provides a more idealistic situation from the viewpoint of the company. Real Cost of Capital tends to be widely used by companies, since this provides a more accurate depiction, having factored in inflation, as well as other metrics including time value of money.
The main underlying difference between Nominal, and Real Cost of Capital stands to be the inflation related factor. Factually, it can be seen that inflation is an important component that continually needs to be factored in the calculations so that a more realistic view of the company is made possible.
Advantages of using Real Cost of Capital
Cost of Capital is a highly important metric that is used by companies in order to evaluate a company. Basically, it is a metric that is used to make better business decisions that are likely to generate positive returns for the company. As far as Real Cost of Capital is concerned, there are numerous different advantages from the perspective of the company of relying on Real Cost of Capital. These advantages are as follows:
- Real Cost of Capital helps to measure actual value creation. Since inflation is already incorporated, it helps companies to understand the actual value that is generated across a period of time.
- Real Cost of Capital helps to form the financial analysis based on actual cash flow and other frameworks. The concept of time value of money is a very important concept in finance, and hence, all calculations that are done on a ‘real’ basis provide a more realistic snapshot.
- Ease of interpretation and understanding: From the perspective of external stakeholders, it can be seen that all the calculations that are done on a real basis help stakeholders to measure and gauge the actual performance. If Nominal Cost of Capital is used as a discount rate, or a hurdle rate, that would be more confusing since investors would not actually know if the figures presented are accurate or not.
Real and Nominal Cost of Capital – Explanation
The Real and Nominal Cost of Capital is mostly interlinked with inflation. The relation between Real and Nominal Cost of Capital is mostly undertaken using the Fisher Formula. The Fisher formula is as follows:
(1 + i) = (1 + r) (1 + h)
Where r is the Real Cost of Capital, i is the Nominal Cost of Capital and h is the general inflation rate.
Using this formula, the conversion from Nominal Cost of Capital to Real Cost of Capital (or vice versa) can be easily made.
Example and Illustration of Cost of Capital
The Nominal Cost of Capital of a company is 8.0%, whereas the General Inflation Rate is 7%. The Real Cost of Capital in this case can be calculated as follows:
Fishers Formula:
(1 + i) = (1 + r) (1 + h)
(1 + 0.08) = (1 + r) (1 + 0.08)
(1.07)= (1+r) (1.08)
(1+r) = (1.08)/ (1.07)
1+r = 1.009
r = 0.9%
This implies that the Real Cost of Capital of the company is around 0.9%
